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If you listen to the talking heads, there is no end in sight to the Euro crisis.

Even with the European Central Bank's (ECB) recent Long Term Refinancing Operation (LTRO), Greece is still making all the headlines.

As of late last week, a possible new deal has been made in Greece. However, the finance ministers that are responsible for the deal are not sure it will be enough to release the second bailout of Greece.

The ECB has been demanding that debt it bought at a discount be honored at full par value. It is now reported that the ECB will sell these debts at cost, and allow the debt to be retired.

This is a huge first step in the process of getting Greek debt levels low enough to be sustainable.

Yet, we are still well into the second year of this crisis and the market is growing tired of endless European emergency meetings.

It reminds me of the period around January 2009.

The reality is Europe needs to go through a hard, brutal adjustment period, where the weak states that cannot handle being in the European Union (EU) leave.

While a New Greek deal has been announced, few people believe it will be the last deal, or the best deal. That is, if it is even ratified in the end.

"It's up to the Greek government to provide concrete actions through legislation and other actions to convince its European partners that a second program can be made to work," EU Economic and Monetary Affairs Commissioner Olli Rehn said.

The rolling bailout process appears to be set up to happen this spring, as the ECB pumps fresh liquidity into its banks for unlimited dollar amounts. The drain on the balance sheets of Euro banks appears to be ending.

The ironic angle few people are tracking is that U.S. banks have been helping to drive Europe's big banks into this crisis.

Setting the Stage for the Second LTRO

Let me explain.

U.S. banks have loaned money to European banks via our money market accounts for periods between seven and 270 days on average.

So when you left cash in your money market account, a significant portion of that cash was actually being invested in unsecured loans to European banks in a search for higher yield.

These funds were typically rolled over at the current market rates, allowing Euro banks access to shorter-term liquidity. However, that began to change in July 2011 when U.S. banks started shortening the terms of the funds or flat out began to repatriate them.

This shift by American banks caused European banks to lose access to what they were using for near-term liquidity. European banks were using short-term loans to make longer-term loans to their clients.

The process of paying back their short-term funding, while still holding onto longer term loans has stretched their balance sheets even more.

This reversal of funding caused an expansion of the leverage at the banks, as they have loans outstanding but have to pay back the source of them.

As result of this liquidity crunch, the ECB rolled out a program to allow banks to recapitalize themselves.

It's called the LTRO (Long-Term Refinancing Operation). Think of it as being like the U.S. Troubled Asset Relief Program (TARP) but for Europe's banks.

The LTRO allows banks to bring their loans to the table, turn them in with a small haircut, and receive cash/capital in return.

The first of the LTRO operations was in late 2011 and raised about $500 billion in funds for the banks. The loan terms are amazing. The ECB is charging just 1% for these new funds, which are good for three years.

This will allow banks to deposit those long-term loans at the ECB and get back cash at a discount to help lower their risk levels.

The second LTRO is scheduled for Feb. 29, with estimates that it may be two or three times the size of the first.

A Massive Injection of Cash

If so, combined we are talking about as much as two trillion additional euros that may be injected into the European banking system in a short period of time. This capital will be put to risk.

Like the TARP, these funds will allow Euro banks to take risk again – if only to try and pay back losses and capital haircuts they've had to take.

Here is the issue: that money will seek the highest rate of return as it trickles down to the banks' trading desks.

This means it will most likely show up in places like commodity prices, and bank and sovereign debts trading at a discount to par. Banks are being encouraged to leverage up on their host nations' sovereign debts.

While the market never repeats, it does rhyme sometimes.

It's my expectation Europe is preparing to recapitalize its banks via LTRO to help them weather the coming storm when Greece officially leaves the EU and the focus turns to other weak member states.

Remember, whatever deal Greece cuts now, Portugal and Ireland will want to renegotiate their deal. The Greek drama is only the first act. There is going to real market impact when the second LTRO is finalized.

What happens after that will be very noteworthy…

Soon, thanks to the LTRO, European blue chip stocks could be an interesting place to put speculative funds to work again.

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Dom

If I'm reading this right, you seem to say the Euro banks will be given this wonderful new liquidity pool to recap themselves, and will just turn around and use it to speculate on commodities and sovereign / bank debt.

Short-term this may be bullish, but long-term this can't be good can it? Unless a 2nd cr. bubble is a good thing…please explain if I'm off-track

Dom

Vote Up0Vote Down Reply

February 14, 2012 1:49 am

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Carlos

Bullish for few months then back to the same drama again…its going to be LTRO after LTRO after LTROs till it will implode on its own weight.

Vote Up0Vote Down Reply

February 16, 2012 12:51 pm

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